Pay Off Credit Card Debt or Build an Emergency Fund?

If you’re at least three months behind paying some of your bills, those debts are considered delinquent. If you’ve got a lot of them, you’re not alone. Even though the recession is supposedly "over,"  plenty of people are still hurting. Over half a million Canadians were more than 90 days past due on their credit payments as of May 31, 2009, according to credit bureau Equifax Canada.

In this situation, the usual financial advice is to use your extra cash to pay off your debts to avoid paying as much interest as possible. Henrietta Ross, a spokesperson for the Ontario Association of Credit Counselling Services, had a different suggestion, however. In an interview with CBC, she recommended people put aside six to eight months worth of savings, in case of a financial blow like job loss.

Opposing viewpoints

Financial experts disagree on which is more important — saving for emergencies or paying down debt. When the CBC asked financial planners in January 2009 for their advice to a fictional family trying to decide where to spend money, they received different answers. "The big thing for me is to make sure that they get rid of their bad debt — which I consider credit-card debt to be," said Judith Kane, a financial advisor in Eastern Ontario.

"The first thing I think is that you need to make sure that your family can keep your roof over their head," said Sandra Foster, a financial consultant and writer, "so to me that's having some money for emergencies." A consumer needs to both pay off debt and save emergency funds, but one action or the other must take priority.

The advantages of paying down credit card debt

Prior to the recession, the traditional advice was to pay down credit card debt first, in order to:

• Save money that you would otherwise be racking up as interest on an unpaid bill.
• Free up credit so that you can use it in case of emergency.
• Improve your credit score and protect your long-term financial health.

The advantages of building a healthy emergency fund

Many banks recommend saving three months’ worth of expenses or income. The RBC even offers a calculator to show how much you need, based on your income. An emergency fund lets you:

• Have a cushion to fall on in case of job loss, major automobile repairs, or illness.
• Have a guaranteed source of money that can’t be cut back, cancelled or refused, the way a credit card can.

In the wake of the recession, many financial experts have advised people to sock away cash in an emergency fund and just make minimum payments on their credit card bills. If your job suddenly disappears in this harsh climate, you will still have a cushion to fall back on.

But the recession has also resulted in dwindling interest rates, so your saved money won’t make nearly as much as your credit card interest is costing you. Saving for an emergency fund can take many months, and your credit-card interest will build that whole time.

Example:

You have $5000 in a savings vehicle with a 1% rate of interest, and a $5000 credit card bill at 19.75% interest.

• At the end of one year, you have: $50 in savings account interest
• At the end of one year, you have: $987.50 in credit card debt

How do I decide between paying off credit card debt and saving for an emergency?

It depends on your situation. If you are a renter, a worker in a stable industry (like government), single, or childless, you should focus on paying down credit card debt and building a small emergency fund. Your expenses are relatively low, and your income should be secure.

On the other hand, if you are a homeowner, a parent, or working in a volatile industry (like automotive manufacturing), focus on your emergency fund. If you lose your job, your roof starts leaking, or your car dies, a reserve of money will keep you from putting even more on your credit card. Continue making payments on your credit card to protect your credit score, and once your emergency fund is adequately stocked, focus again on paying down your debt.